Dealmania vs. the Conglomerates

September 27, 2005

By Steve Rosenbush Dealmaking got off to a torrid start in 2005, and the pace hasn't let up since. The year began with Procter & Gamble (PG) announcing in January it would acquire Gillette (G) in a $54 billion transaction. A few weeks later, telecom giant SBC (SBC) said it would buy AT&T (T) for $16 billion. Then Verizon announced plans to acquire MCI (MCIP) for $7.65 billion.

Flash forward to September -- and deals continue to dominate business news. Oracle (ORCL) recently announced it will buy rival Siebel (SEBL) for $5.85 billion, eBay (EBAY) will acquire Internet phone upstart Skype for $4.1 billion, and Ford (F) said it would sell its Hertz car rental unit to Carlyle Group and other private-equity investors for $5.6 billion.

The third fiscal quarter ends on Sept. 30, and 2005 could well be the busiest year for M&A since year 2000, with $745 billion in transactions as of Sept. 27, according to analyst Richard Peterson of Thomson Financial. Deals in 2004 totaled $829 billion, which was up sharply over the preceding three years, although it's only half the record $1.7 trillion done in 2000.

DISCIPLINED PLAYS. What's driving the M&A boom? After the double shocks of the tech bubble bursting in the late '90s and the September 11 terrorist attacks, investors and CEOs have recovered their confidence, but not their swagger. These days, companies are focusing laserlike on their core markets -- and selling off businesses that don't fit snugly.

Gones are the "visionary" deals of the late '90s, when companies bounded into new markets -- think of Time Warner (TWX) merging with AOL, or AT&T buying its way into the cable-TV business. AT&T has since bailed out of cable and signed a deal to sell itself to SBC. Time Warner is still struggling to make the AOL acquisition work.

In their stead are disciplined M&A plays with back-to-basics intent. Ford has announced it's selling Hertz so it can concentrate on making autos again. Pitney Bowes (PBI) is getting out of financial services. Sara Lee (SLE) is shedding noncore assets. Even Wendy's (WEN) has announced it intends to sell 15% to 18% of its Tim Horton's donut chain to the public after facing investor pressure for a total spin-off.

"The market has been rewarding focused companies for the last few years. And in the next year, we will see an unprecedented number of companies shedding noncore assets," says Rob Kindler, head of the global M&A group at JP Morgan (JPM).

STUMBLING GIANTS. So what's ahead? More pressure on big conglomerates like GE (GE) and Tyco (TYC) to follow the parade and simplify their structures, too. In a new age of increasing shareholder activism, investors may loose patience with stodgy results. Mighty GE has seen its stock slide to $33.40 recently, from $57.68 in September, 2000.

Indeed, the four companies that make up the S&P conglomerates group have underperformed the market over the last five years. The market-weighted return for the companies -- GE, Tyco, 3M (MMM), and Textron (TXT) -- is a negative 8.7% over the last five years, according to S&P analyst Howard Silverblatt. The S&P 500 has lost 3.3% in that period.

A breakup of one or more of the big conglomerates is "very possible," says Rich Maroney, editor of the Dow Theory Forecasts newsletter. He says the real question is whether investors believe that the management of a large conglomerate adds value to its individual businesses.

CULTIVATING DIVERSITY. Maroney thinks GE can still make a strong argument that its individual businesses are worth more as part of the whole company. The reason: strong financial and managerial talent in each.

GE, for one, isn't ready to change its structure. Spokesman Russell Wilkerson says businesses in the GE portfolio are expected to generate 8% organic growth. The giant is spinning off companies that don't produce that growth, such as its Genworth insurance business. But Wilkerson says the idea of the diversified industrial business is still valid. "The portfolio gives us great capabilities in a global economy," he says.

Likewise, Tyco may come under pressure to spin off assets or even break itself apart. Its shares closed at $28.16 on Sept. 27, down from $51.87 on September 30, 2000. Tyco says it isn't ready to abandon its structure either. But spokeswoman Sheri Woodruff says Tyco has "no aversion to disposing of assets where we don't see a close fit." With a target of organic revenue growth of 4% to 5% a year, Tyco is parting with a plastics business, for example.

BUYERS WITH PATIENCE. In general, Tyco has already focused its operations, she says. It may also be on the hunt for specific "bolt-on" acquisitions, ending a moratorium on M&A. Such deals would make most sense in core markets like health and electronics.

Other dynamics are at work in spurring the breakup of conglomerates. Kindler points to the increasing power of shareholder activists such as Carl Icahn, who's pressuring Time Warner to sell AOL. Investors reward managements that follow such advice. And companies that want to shed assets have ready buyers among private-equity firms that are willing to take a few years to turn around or build up assets that don't suit impatient public investors.

Plenty of potential buyers are in the market. Cash on corporate balance sheets is at a record high level (see BW, 7/18/05, "Too Much Cash, Too Little Innovation"). Global private-equity firms alone have about $1 trillion to put into deals, up from about $200 million in the '90s, according to Boon Sim, head of M&A for the Americas region at Credit Suisse First Boston.

LOUDER CALLS? "We're in the early stages of an M&A cycle that could last four or five years," Sim says. And Sim agrees that general industrial companies will play a larger role in the M&A market, as buyers or as sellers of assets. "We haven't seen it yet, but we will," he says.

GE shares have been flat since June, and Tyco shares have been weak since last spring. With corporate firebrands like Icahn pushing for big stock buybacks and asset sales at Time Warner, louder calls for structural changes at other big, diversified companies could well be next.